Europe Part 2: The Smart Beta PortfolioLearn more about this firm
In our last post we discussed the attractiveness of European equities in aggregate, and assessed the pros and cons of implementing this regional investment theme with a market capitalization weighted ETF (VGK – Vanguard). It was our conclusion that the most effective way to gain exposure to the expected advance in European equities was through a multi-factor “smart beta” portfolio. This intelligently constructed portfolio would dismiss market capitalizations (company and country size) and instead focus on systematically weighting developed European countries based upon country level fundamentals, momentum, risk, and valuations. This balanced, repeatable, multi-factor process exposes investors to some of the primary drivers of equity market returns – strong fundamentals, positive momentum, low risk, attractive valuations, and consequently, the size effect.
Entering April 2014, our overall assessment of Europe in aggregate was positive. However, with more than 70% of Developed Europe ETF assets allocated to only 4 countries, we set out to build a better portfolio and improve the implementation of this investment theme for our clients. Our research supports a balanced investment process that incorporates data from more than 40 indicators spread over 4 factor “buckets”. While a value focused investor may prefer Austria, and a momentum focused investor may prefer Italy, our research suggests integrating value and momentum, as well as fundamentals and risk, into the portfolio construction process. This data driven and disciplined investment process reveals that every country in Europe is different and the attractiveness of each country changes over time. Of course, there are some macro level factors, or systematic risks, that do impact all countries in Europe, but as those systematic risks dissipate the dispersion in country returns should increase and country selection should become the key to exploiting attractive risk adjusted returns from the region. As of April 2014, the attractiveness of France is very different from that of Spain, and the attractiveness of Switzerland is very different from that of Sweden. These variations between attractiveness and market capitalization are at the heart of the “smart beta” vs. market capitalization discussion.
From a multi-factor perspective, the most attractive countries in Europe include Germany, Spain, Sweden, Italy, and Denmark. After “x-raying” the VGK ETF and looking down into the underlying holdings, we found that only 29.3% of its assets are allocated to these five “most attractive” European countries. Conversely, our analysis suggests that Switzerland, Ireland, and France are the least attractive countries in the region, and these three countries command 29.7% of the VGK assets. Accordingly, we continue to advocate using portfolios that concentrate on allocating capital to the most attractive countries (on a multi-factor scale) rather than an index based portfolio that allocates capital based upon size and market capitalization.
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Charts and information used in this report are sourced from AGA. Commentary marked by “*” are sourced from Vanguard, Bloomberg, and Accuvest, respectively.